Tobin’s q Analysis – Should investors buy their stocks?

The Tobin’s q was examined as an indicator of the firm’s effectiveness from an investment perspective across a variety of top management games. It was developed by James Tobin (Tobin 1969) as the ratio between the market value and replacement value of the same physical asset:

First, the numerator is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for the newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.

If the market value reflected solely the recorded assets of a company, Tobin’s q would be 1.0.

If Tobin’s q is greater than 1.0, then the market value is greater than the value of the company’s recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. High Tobin’s q values encourage companies to invest more in capital because they are “worth” more than the price they paid for them.

If a company’s stock price (which is a measure of the company’s capital market value) is $2 and the price of the capital in the current market is $1; the company can issue shares and with the revenue invest in capital. In this case q>1.

On the other hand, if Tobin’s q is less than 1, the market value is less than the recorded value of the assets of the company. This suggests that the market may be undervaluing the company.

Below table and exhibit show the three airlines company and their three year Tobin’s q values. We use the formula to generate to Q value:

In case of the comparison of Southwest Airlines with its two major competitors, we can see that Southwest’s q value is relative stable and remain in positive values. Though the chart of American Airlines is relatively flat and as stable as Southwest did, it has a negative value each year. The Delta Airline‘s graph is choppy and extremely unstable. As to the investor prospect, Southwest Airlines is a relatively robust investment object compared to the other two companies.